To say the Jack Schwager’s series of Market Wizards books have influenced a generation of traders would be a gross understatement. I cited Jack’s original Market Wizards book in my book and mentioned it last year as an influential book on my outlook on the markets. After a bit of a hiatus Schwager is back with a new book Hedge Fund Market Wizards. This series of interviews focuses on managers who have a demonstrated track record of performance based on their ability to generate returns relative to risk. I recently had a chance to send Jack some questions I thought Abnormal Returns’ readers would find of interest. Since Jack was generous in his responses I am going to run a post later with some additional questions.
AR: Much of what your interviewees talk about is in my mind second order thinking. By that I mean people who haven’t traded before may have a tough time grasping some concepts on the first read. For example, Colm O’Shea makes an important point that investors often set their stops based on how much they can lose in contrast with levels that reflect a true test of a trader’s hypothesis. This reflects the broader idea of learning from your losses. Are there some ways novice traders can better approach losses as a learning device?
JS: Your question actually touches upon two separate but important points. First, the tendency for many traders to use the wrong criterion in setting their stop points and second how traders can learn from their losing trades. Let me address these points in turn.
First, on the matter of stops. O’Shea points out that many traders select their stops based on the amount of loss they can tolerate, given their entry-level and position size. He says these traders have it backwards. Instead, they need to first determine the market price that will disprove their trading hypothesis and then size their position based on their loss tolerance. The key point is to make sure that stops are based upon meaningful price levels, not pain thresholds.
In regards to learning from losses, one of the managers I interviewed, Ray Dalio, the founder of Bridgewater, the world’s largest hedge fund, stressed that learning from mistakes is the most important way traders can improve. In fact, learning from mistakes is one of the philosophical tenets by which Dalio runs his hedge fund. Employees are even encouraged to criticize other employees for their mistakes, including superiors, in the interests of improvement. Any time you make a trading mistake, I believe it is a good idea to write up a summary of the trade and the mistake made, in effect maintaining a trader’s log. Only trades that provide learning lessons would be included. These would include mostly trading mistakes, but could also include trades where the correct decisions were made and provide a learning lesson. Keeping such a trader’s log and reviewing it periodically can be an important aid in helping a trader reduce future mistakes.
I should add here that readers shouldn’t confuse losing trades with trading mistakes. A losing trade does not imply any mistake was made. In any trading process, including a consistently winning one, some percentage of trades will be losers. As long as you stay consistent with your approach, the trade was not a mistake, regardless of whether it won or lost. The key question is, if faced with all the same facts, would you make the same trading decision all over again? If you would, then the trade was not a mistake, even if it lost money.
AR: Many of your interviewees talk about structuring trades in the most advantageous way possible. In short, the obvious implementation of trade may not have the positive asymmetries that traders are looking for. In that light and reflecting the issue of limiting losses in the prior question does it make sense for beginning traders to focus on using options to implement trades? There is a steeper learning curve but it seems like options provide some key benefits not found in trading the underlying.
JS: I am glad you asked that question. The long side of options is one of the best and simplest ways traders can establish right-skewed, asymmetric trades—that is, trades that have the potential for large gains if they are correct, but only a limited loss if they are wrong. There is a popular notion that buying options is a fool’s game because, on balance, options are overpriced in the sense that implied volatility tends to be higher than subsequent realized volatility until expiration. It is true that, on balance, buyers of options will lose money. In fact, it couldn’t be any other way. Sellers of options are providing insurance, and there has to be some incentive—read profit margin—in order for some market participants to be willing to take the unlimited risk of being sellers of options. Just like sellers of home insurance will collect more in premiums than the claims they pay out, it is only reasonable to expect that the sellers of options will collect more premiums than the losses they realize from options that expire in-the-money. So at first glance, it may appear that buying options is not a good idea. This perception, however, misses a critical point. The buyer of options actually has a big advantage—namely, the buyer can choose when to buy an option. So while being long options all the time is a losing strategy, selectively buying options when there is a perceived large opportunity relative to the risk premium can be a very effective strategy, leading to right-skewed results. Of course, the key is that the trader has to have some ability in selecting these opportunities.
Thanks to Jack for participating. Stay tuned for another question and answer tomorrow. You can find Jack’s latest book, Hedge Fund Wizards at Amazon. For those interested in other interviews Jack has done check out his interviews with Michael Martin of MartinKronicle and Andrew Horowitz of The Disciplined Investor podcast.
*Disclosure: We received a copy of Hedge Fund Wizards from the publisher.